Quite Dismaying

The bulls are all starting to fret
As rallies in stocks and bonds get
Their first taste of trouble
Were they in a bubble?
Perhaps, but we don’t know quite yet

Thus pundits all over are saying
Last week, while it was quite dismaying
Is likely to be
A hiccup, you’ll see
Meanwhile, everyone is out praying

If there is one notable thing from the press this weekend and this morning it is that almost universally, reactions to last week’s asset price declines have been, ‘don’t worry, it’s nothing.’ Now I will be the first to say that just because stocks fell 2.5% on Friday is not a sufficient signal that the end of the bull run is nigh. However, I do think it is important to remember what seemed to be the trigger of the move, and why the potential exists for further declines. And given the extremely high correlations amongst asset classes these days, declines in one asset are likely to lead to declines in all assets!

As I’m sure you recall, last week was a rocky one for asset prices before we got to Friday. While stock prices seemed to be stabilizing on Wednesday and Thursday after a rough beginning of the week, Treasury prices never slowed in their descent. Ironically, it was the AHE number on Friday, showing a 2.9% annual rise in earnings in January, that seemed to be the catalyst for the much sharper fall in Treasury prices and the collapse in stock prices. This is ironic because for the past five years at least, the Fed has lamented that wage gains have lagged so badly and they were working hard to push those wages higher. And yet, as soon as there was any inkling that they may finally be having some success in their endeavors, investors turned tail. The point is, if you needed proof that the key driver behind the asset market rallies of the past eight years was the extraordinary monetary policies of the central banks, then here it is. The chain of thought is that if inflation is finally starting to pick up, especially if it is picking up faster than expected, the central bank community will collectively stop adding liquidity to the system, and will in fact, withdraw some of the excess liquidity that already exists. Without that excess liquidity floating around, investments are going to have to stand on their merits. And that is a much tougher thing for anyone or anything to do!

Now it is entirely possible that we have already seen the worst of what is coming, and the idea that global growth will continue apace means that equity prices should never fall again, but I have to say that there are some ominous signals. First, the FOMC statement was clearly a bit more hawkish than anticipated, which implies that the Fed is ready to respond to rising inflation. Second is that in terms of experience on the Fed, in 2018 there will only be two voters, Powell and Brainerd, who have a history of voting for the past twelve months. This matters because so much of the recent financial market experience has been a complex dance between the Fed and investors/traders, with the communication strategy a critical aspect. However, now we have a Fed with extremely limited experience in terms of that communications dance, and so more likely to make a statement that doesn’t fit the meme. (Consider the Mnuchin weak-dollar comments from two weeks ago and the uproar they caused not only in the FX market but in the central bank community as well.) The point is that the perception of a policy error has grown dramatically. Finally, given the way inflation is calculated, the idiosyncrasies that drove it lower last year (remember unlimited cell-phone data plans?) are going to fade from the data, which means that the base effects are going to allow for higher readings going forward. Now, there is a large contingent of (Keynesian) economists who have started arguing to allow inflation to run hotter than the 2% target as they want to delay the Fed from raising rates further. However, one of the key things to remember about Chairman Powell is that he is not an economist, which means he is not necessarily Keynesian in his views. In fact, as a former banker, he is likely well aware of the damage that inflation does to the economy. My read is there is every chance he leans more hawkish than Yellen ever did, and that the consequence will be more declines in asset prices. Certainly, if inflation continues to tick higher, the back end of the yield curve will continue to steepen regardless of what the Fed does.

Now tying it all to the dollar is simple. The changing rate structure in the US is going to ultimately be seen as an attractive place to park funds. While the dollar could well show some further weakness in the near term, I continue to see it benefitting by the end of the year. The bigger risk, in my mind, is that the asset price decline gains serious traction and stocks fall 20% in the next month or two, at which point a general risk-off sentiment will be taking hold and the dollar should benefit sooner.

Now that I’m finished with last week, the week ahead seems much less interesting on its face. Overnight, the dollar has had a mixed performance with no significant movers in either direction. We did see Services PMI data from the UK (weaker than expected at 53.0), which pushed the pound a bit lower as well as from the Eurozone (stronger than expected at 58.0), which was unable to move the euro at all. It seems to me that the FX market is looking to the US equity markets for its cues right now, and while futures are pointing lower, the losses aren’t that large, hence the dollar’s indecision.

As to data this week, it is a pretty light calendar overall as follows:

Today ISM non-Manufacturing 56.5
Tuesday RBA Rate Decision 1.50% (unchanged)
  Trade Balance -$52.0B
  JOLTS Job Openings 5.90M
Wednesday Consumer Credit $20.0B
Thursday BOE Rate Decision 0.50% (unchanged)
  Initial Claims 232K

We do hear from seven Fed members this week, ranging across the spectrum from doves to hawks. It will be interesting to see if Friday’s data has moved the needle a bit further to the hawkish side and if they are going to start leading the market in that direction. We shall see. Overall, I feel like the dollar will remain rangebound this week as there are too many conflicting issues to allow significant movement in either direction. So for now, keep an eye on Treasuries and stocks, they will be key to everything.

Good luck